Big Money Thinks Small

Biases, Blind Spots, and Smarter Investing

Joel Tillinghast

• Publisher: Columbia Business School Publishing
• Year: 2017
• ISBN:
  9780231544696
• Topic: Personal Development
• Subtopic: Personal Finance

Market mistakes to avoid: "Written for investors at all levels…[a] practical, no-nonsense guide."— Publishers Weekly One of Money Week 's Five Best Books of the Year Investors are tempted daily by misleading or incomplete information. They may make a lucky bet, realize a sizable profit, and find themselves full of confidence. Their next high-stakes gamble might backfire, not only hitting them in the balance sheet but also taking a mental and emotional toll. Even veteran investors can be caught off guard: a news item may suddenly cause havoc for an industry they've invested in; crowd mentality among fellow investors may skew the market; a CEO may turn out to be unprepared to effectively guide a company. How can one stay focused in such a volatile world? If you can't trust your past successes to plan and predict, how can you avoid risky situations in the future? Patience and methodical planning will pay far greater dividends than flashy investments. In Big Money Thinks Small, veteran fund manager Joel Tillinghast shows investors how to avoid making these mistakes. He offers a set of simple but crucial steps to successful investing, including: · Know yourself, how you arrive at decisions, and how you might be susceptible to self-deception
· Make decisions based on your own expertise, and do not invest in what you don't understand
· Select only trustworthy and capable colleagues and collaborators
· Learn how to identify and avoid investments with inherent flaws
· Always search for bargains, and never forget that the first responsibility of an investor is to identify mispriced stocks

PART I

Sleight of Mind

1

It’s a Mad, Mad World

Your beliefs become your thoughts, your thoughts become your words, your words become your actions, your actions become your habits, your habits become your values, your values become your destiny.

—MAHATMA GANDHI

DO YOU WANT TO BE RICH? Economists consider the question absurd, because the answer is so obviously YES! Unless the notion of building wealth appealed to you, I doubt you would be reading a book about investment decisions. Still, it’s unwise for me, or anyone, to assume too much about motives, beliefs, and decision-making. A key theme of this book is that in the investment world reality is not as it appears, and often the ideal differs from both appearances and reality. Nor do we actually choose in the rational way that we think we do. And our choices aren’t perfect—we all make decisions we later regret.

This book is about succeeding in investing by avoiding mistakes. The organizing framework of this book, in five parts, is that we will reap pleasing investment rewards if we (1) make decisions rationally, (2) invest in what we know, (3) work with honest and trustworthy managers, (4) avoid businesses prone to obsolescence and financial ruin, and (5) value stocks properly. While the stories in this book about my mistakes will be most readily grasped by readers who have made their own investment mistakes, I hope this book offers a wider audience an opportunity to learn from the mistakes of others and provides some entertainment value.

I have run the Fidelity Low-Priced Stock Fund (FLPSX) with an intrinsic value approach since 1989, and it has outperformed both the Russell 2000 and Standard & Poor’s 500 indexes by 4 percentage points a year. Over twenty-seven years, a dollar invested in FLPSX grew to $32, while a dollar invested in the index grew to $12.

However, the world of businesses and stocks changes constantly. What’s worked in the past may not continue to work. More importantly, investors are diverse, with different emotional constitutions, aptitudes, knowledge, motivations, and goals. One size decidedly does not fit all. And because we’ve just met, I shouldn’t leap to conclusions about you.

“What Happens Next?” and “What’s It Worth?”

Most investors seek to answer two questions: “What happens next?” and “What’s it worth?” Our minds naturally leap to reply to the first question, often before we realize that it was even posed. The stock price has been going up, so what happens next is that it will go up some more—unless, of course, it goes down. A company reports catastrophic financial results. Then earnings forecasts get slashed. The stock price dives—that is, unless the market knew it was going to be a bloodbath and is relieved that management’s guidance wasn’t more dismal. Unavoidably after whatever happens next, something else will happen, and you may not be ready for it. The question of what happens next is an endless treadmill of, “And then what?” Many of those answers will be wrong.

The longer your time horizon, the more likely you are to be a step ahead of other investors. Mindful investors will look out for at least a few iterations of what happens next. The answer to the second instance of “What happens next?” depends somewhat on the first, and the third on the second and possibly on the first too. And so it goes. Suppose, for example, a company has developed a marvelous new product. This often leads to strong sales and high profits. But high profits draw competitors, and that means…Sometimes, the first company to launch a product is the winner and takes it all. Other times, the pioneer is the one with arrows in its back, warning where not to go. Correct or not, I don’t know how to convert these answers into investment decisions.

“What’s it worth?” is an even more involved question. Many ignore the question of value because they think it’s too tough to answer. Others don’t ask it because they assume a stock’s price and value are the same. They suppose a stock is worth exactly what it can be sold (or bought) for. If you must sell in a hurry, you will receive market price, not value. However, the central idea of value investing—of which I am an advocate—is that price and value are not always equal, yet should be at some date in the future. Because the date is unknown, patience is mandatory.

Proof of worth arrives years later, long after the decision to buy or sell. Value can be shown only indirectly, never precisely, as it is based on projections of earnings and cash flows into the unfathomable future. Forecasts will always be guesses, not facts. In many cases, the actual outturn will depend more and more on what happens over time. If this year’s losses are particularly horrific and the firm goes under, well, it really was a terminal value. Most people don’t have the patience to muddle through anything as slow and sketchy as valuation.

Answering “What’s it worth?” demands patience and low turnover. but the seemingly easier path of constantly buying and selling based on “What happens next?” doesn’t work for most investors, even professionals. A portfolio’s turnover is defined as the lower of purchases or sales, as a percent of assets, so a portfolio with 100 percent turnover would change its holdings completely every year. Mutual funds are directed to file data on their holdings and turnover with the U.S. Securities and Exchange Commission, so their behavior is a matter of public record.

Broadly, most studies show that the higher the turnover, the worse the fund does (see table 1.1). Every study I’ve seen shows that mutual funds with portfolio turnover greater than 200 percent perform badly. Those with turnover above 100 percent fare a bit better, but not much. The studies don’t agree about whether the best level of turnover is moderate or as close to zero as humanly possible. Mutual funds with turnover below 50 percent are more likely to be using a reasoned, patient approach—like value investing.

Table 1.1

Mutual Fund Turnover and Excess Returns

Turnover Quintile	Avg. Turnover Rate	Annual Excess Returns
High 1	128%	− 0.24%
2	81%	− 0.31%
3	59%	+ 0.07%
4	37%	+ 0.33%
Low 5	18%	+ 0.10%

Source: Salim Hart (Fidelity), Morningstar-listed active equity funds with more than $0.5 billion in assets.

Folklore and Crowds

Historians, psychologists, and economists describe behavior in stock markets differently. For centuries, the folklore of stock exchanges has depicted them as crowded, anonymous carnivals of mass delusion and mayhem, with a whiff of sin. In a venue where avarice and envy are constants, no one expects decisions to be morally ideal. Financially, the greatest dangers stem from misunderstanding reality, which leads to endless cycles of boom and bust. These include the Dutch tulip mania, the South Sea Bubble, the Great Crash, Japan’s asset bubble, and dozens more—including, yes, the tech and housing bubbles. Investors believed they were taking part in adventures that would reinvent the world. When the bubbles popped, investors were left with wasted capital, scams, and crushing debt.

French polymath Gustave Le Bon wrote The Crowd in 1895 as a rant on French politics, but his observations also describe how stock market manias occur. Under the influence of crowds, individuals act bizarrely, in ways they never would alone. Le Bon’s key theme is that crowds are mentally unified at the lowest, most barbaric, common denominator of their collective unconscious—instincts, passions, and feelings—never reason. Being unable to reason, crowds can’t separate fact from fiction. Crowds are impressed by spectacle, images, and myths. Misinformation and exaggeration become contagious. Prestige attaches to true believers who reaffirm shared beliefs. Crowds will chase a delusion until it is destroyed by experience.

British investors couldn’t resist the image of cities of gold in the New World, inflating the South Sea Bubble. Today, El Dorado might be imagined as no-stick blood tests, colonies on Mars, or solar-powered driverless cars. Investors can be as ardent about stocks like Facebook, Amazon, Salesforce.com, or Tesla as about religion or politics. Professional fund managers should be less susceptible to pressures to fit in and conform than individuals, but…We have quarterly and annual critiques of our relative performance and deviations from benchmarks, and clients who yank their accounts when we are behind in the derby.

The South Sea Company was launched in 1711 as a scheme to privatize British government debt. The Crown granted South Sea exclusive rights to trade with South America. Holders of government annuities (bonds) could swap them for South Sea shares, and South Sea would collect the bond interest. Interest income was to be South Sea’s only source of net earnings. While international trading provided speculative sizzle, South Sea never made a profit from it, even after it added slaves to its cargo. Nonetheless, over half a year, its share price vaulted eightfold to a peak near £1,000 in June 1720. King George I was honorary governor of the company, and much of London society was sucked into the mania. Shares were offered on an installment plan. Others borrowed money to buy shares. South Sea shares plunged to £150 over a few months and dipped below £100 the following year, ruining many who had used leverage.

There were five categories of mistakes made during the South Sea Bubble, in which investors did the opposite of the five key tenets of this book. First, make decisions rationally. The decision to invest in the South Sea Company reflected a shared hallucination about cities of gold in South America. True, commerce with English-speaking North America had been lucrative, but South America was mostly Spanish territory. When the facts can’t be readily ascertained, we go with the (often erroneous) judgments of those in authority. The king’s share ownership and position at South Sea was surely counted as an endorsement. The fear of missing out (FOMO) sounds laughable until you’ve witnessed folks around you pocketing unearned windfalls. FOMO can be overwhelming! Sir Isaac Newton, the renowned physicist, is reported to have lost money on the South Sea Bubble and then to have said, “I can calculate the motions of the heavenly bodies, but not the madness of the people.”

Second, invest in what you know. Nothing in the experience of most investors in the South Sea Company equipped them to quantify the benefits of trade with South America. Ocean journeys were long and slow, and few had been outside England or spoke Spanish. Investors may not have grasped that it was in Spain’s interest to monopolize trade with its own colonies. Royals and the landed gentry were at the top of the social order, where too much familiarity with business was considered a demerit. The only English people who might have had any idea of how profitable voyages to South America might be were pirates.

Third, work with honest, capable management. The promoters of the South Sea Company had no experience at, or interest in, operating shipping routes and were bent on making money off of shareholders, not with them. Then, as now, government-granted monopolies eliminated competition and were typically lucrative—but some might sense a criminal aspect. Share options had been given to members of the ruling class, including King George I, his German mistresses, the Prince of Wales, the Chancellor of the Exchequer, and the Secretary to the Treasury. The promoters of the South Sea Company issued shares at inflated prices. In its largest offering, shares were swapped for government annuities with a notional value three times as great. In the aftermath, John Aislabie, the Chancellor of the Exchequer, and others were impeached and imprisoned, and dozens were disgraced.

Fourth, avoid competitive industries and seek stable financial structures. The nature of the South American trade and the financial structures around shareholdings made failure inevitable over time. The English Crown was not free to grant the monopoly, as it was in Spain’s interest to maintain control over trade with its colonies, and England was no ally. France had ambitions as well, leaving the long-run prospects for South Sea routes murky. Purchases of South Sea shares were also funded in ways not built to last. Many government officials received shares without paying cash up front, which could be seen as an option—or a bribe, as they could simply collect the net gain. Shares were offered publicly on installment terms, with an initial payment and two later payments, while others borrowed money to buy shares. When the bills came due, many sold shares to raise cash.

Finally, compare stock prices with intrinsic value. The market price of South Sea stock was totally disconnected from any realistic estimate of value. Intrinsic value is the “true” value of a stock, based on the dividends it is expected to pay over its entire remaining lifetime. Archibald Hutcheson, a Member of Parliament who opposed the scheme, calculated in the spring of 1720 that the shares were worth £150, while the market price was many times that. Hutcheson’s estimate of value was based largely on South Sea’s interest income. Over previous years, South Sea’s expeditions had produced losses (and would continue to do so in the future), so it might have been fair to say that those operations had no value. In 1720, South Sea paid a dividend that—unsustainably—exceeded its net income, making its yield an unreliable indicator of value.

The madness of crowds explains some of the misjudgments in the South Sea Bubble, but not all of them. On their own, people are perfectly capable of not knowing what they don’t know. As investors, we’re trying to assess the decisions and durability of organizations, which isn’t quite crowd psychology. The process o...